With the significant ups and down in the stock market recently, many investors are eyeing trading opportunities in stocks to add gains to their portfolios. The idea may sound enticing but there are many risks associated with this “grand plan”.
Any gains made by holding an investment for a year or less are taxed at ordinary tax rates. Gains achieved by holding a investment more than a year are taxed at the more favorable LT capital gains rates which are 0, 15 or 20 percent depending on the tax bracket of the person. Therefore, by engaging in trading, profits are subject to much higher tax rates. This is why Warren Buffett often says that his tax rate is lower than his administrative assistant!
Ordinary tax rates are assessed every year, so once taxes are paid out of the short term gains, there is less capital to reinvest. Long term capital gains are only paid when the asset is sold.
If an asset is sold after 10 years, no LT capital gains tax is paid until it is sold in year ten. A compounding effect occurs in the investment. For example if an investment increases 5% per year, it is not a 50% increase (10 times 5%), but 63% increase (1.05^10). The higher the annual increase the greater the compounding effect and it is exponential. An 8% annual increase translates into a 116% increase over 10 years (1.08^10). Most importantly, LT capital gains are not paid until the asset is sold. This vastly reduces the taxes paid in total on the investment. After all, annual taxes have a NEGATIVE compounding effect on returns.
Now, the key for long-term returns is to own quality investments that grow significantly over longer time periods. Even quality investments have periods that the market undervalues them, but quality investments have strong financial fundamentals that eventually are recognized by the market.
Short term trading is often like predicting the weather and most people know the track record of the weatherman.
Most professional traders are heroes until probability turns against them and they “blow up”. Most hedge funds eventually meet their maker.
So don’t get enamored with the sirens song of trading, it most likely will bring you pain. Just about everyone knows someone who got involved in day trading and look what happened to them.
